Model Portfolio timbo56:SSOF1

When the price of oil moves, there are at least two phenomena that exacerbate the price move, whatever the direction. I call these kickers. When the price goes down, they kick it down further, when price goes up, they kick it up further.

The first is rigs in or rigs out. When the price goes down, rigs are pulled out of service. This has no immediate effect on oil production, because there is a lag between the time a rig starts to drill an oil well, and the time oil is struck, the well is finished and oil production begins. But it does have an effect on oil consumption, because every rig is a direct and indirect user of oil products. First there is the direct use. Power is needed to drill down and to pump mud through the incipient well. This power is typically provided by a 1,000 hp or greater diesel engine that is kept running around the clock. But this is not all, as the pipe and casing used in the drilling represents iron ore that was dug out of the ground, shipped to a steel mill, made into steel using coal that also had to be mined and shipped. Finally, when the steel pipe has been manufactured it must be trucked to the rig site. Of course the roughnecks have to get to the drill site, too. So, add it all together, it still may not be that much, but at a time when demand is falling for other reasons, it helps push it down that much further.

The other kicker is oil use by oil exporting countries. When the price of oil is high, these countries typically go through a boom time that drives up their own consumption. When the price goes down, the opposite may occur. I don’t know that the recent price plunge has kept prices low for long enough to have much of an effect on the consumption of the major producers, so I will focus on the oil used in drilling.

We are now at a point where the number of rigs has been cut by more than half. As the number of rigs started to decline, oil production went up because damage from the fall hurricanes was being repaired. But it has now peaked and is on the way down, with the four week moving average falling by 100,000 barrels per day between April 17th to May 1st. It is likely that there are other, seasonal factors, but it makes sense that the plunge in the number of rigs would show up in decreased production, eventually. That is how supply and demand are supposed to work. But now that prices have started to move up, we are likely to see a reverse phenomenon as more rigs are placed into service. Oil inventories have risen very dramatically over the last six months, but there is a good chance that as prices rise, the effects of rigs being placed back into service will play a role in driving up demand for oil, well before production from new wells starts to fully compensate for older wells drying up. This could help drive the price up sharply.

I predict that before the end of this year the price of oil will reach over $100/barrel, again.